A defined-benefit plan is one set up to provide a
predetermined retirement benefit to employees or their
beneficiaries, either in the form of a certain dollar amount or
a specific percentage of compensation.
Employer contributions to a defined-benefit plan are very
complex to determine and require the work of an actuary. The
assets of the plan are held in a pool, rather than individual
accounts for each employee, and as a result, the employees have
no voice in investment decisions. Once established, the employer
must continue to fund the plan, even if the company has no
profits in a given year. Since the employer makes a specific
promise to pay a certain sum in the future, it is the employer
who assumes the risk of fluctuations in the value of the
There are three basic types of defined-benefit plans:
- Flat benefit plan — all participants
receive a flat dollar amount as long as a predetermined
minimum years requirement has been met.
A plan calls for payment of 20 percent of
average compensation for the last five years, or
$500 per month, to each retiree with at least 10
years of service.
- Unit benefit plan — provides a benefit
that is either a percentage of compensation or a fixed
dollar amount multiplied by the number of qualifying years
A benefit of 2 percent of the average
compensation of the five highest consecutive
years, or a $20 monthly retirement benefit, for
each year of service.
- Variable benefit plan — benefits are based on
allocating units, rather than dollars, to the contributions
to the plan. At retirement, the value of the units allocated
to the retiring employee would be the proportionate value of
all units in the fund.
The maximum annual contribution you can make to a
defined-benefit plan is one that would be projected to yield a
benefit equal to the lesser of $160,000 for 2002 ($140,000 for
2001; this amount may be adjusted for inflation periodically),
or 100 percent of the participant's average compensation for the
three highest consecutive years.
Very few defined-benefit plans provide for the benefits to be
adjusted each year to reflect the effects of inflation (called
the Cost of Living Adjustment, or COLA), so over the years of
your retirement, the value or purchasing power of your benefits
may shrink considerably.
The Pension Benefit Guarantee Corporation (PBGC). With
a defined benefit plan the employer is legally required to make
sure there is enough money in the plan to pay the guaranteed
benefits. If the company fails to meet its obligation, the
federal government steps in. Defined-benefit plans are the only
type of pension insured by the PBGC. The insurance works
similarly to the federal deposit insurance that backs up your
bank accounts. If your plan is covered and the sponsoring
company goes bust, PBGC will take over benefit payments up to a
maximum amount. The insurance protection helps make your pension
more secure, but it is not a full guarantee that you will get
what you expected.